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FOREX STRATEGY

Risk Me, Risk Me not?

trading strategy trade risk strategy

If you are like me, you get dozens of newsletters in your email inbox daily and sometimes hourly.  I delete most of them, but hardly ever unsubscribe because I know one of these days I am going to need the services of those I have chosen to subscribe to in the first place.  One in particular caught my eye recently.  It was from the owner of a yoga studio that opened about a year ago in Santa Monica, California.  I am interested in following the movement and decisions of this particular owner because her business model seems unusual.  She opened her studio and classes are by donation only.  That’s right-you pay whatever you feel is appropriate and you can wait until the class is over to decide what you want to pay.  And, they video stream live classes, on occasion, so that people all over the world can join.  I am watching this business model to see how it’s working.  It’s actually booming!  It appears she is taking a big risk especially during this strained economic time, but I imagine it was quite calculated. As I was reading her newsletter I got to the bottom where she signed off with this quote from Ray Bradbury, “Living at risk is jumping off the cliff and building wings on the way down.”

Maybe her business model was not quite calculated.  Maybe she was just throwing an idea on the wall to see what stuck.  I actually gasped when I read it. As a business owner I understand you have to take some risks and some chances.  No risk, no goodies, as we often say. And, as a trader, of course you have to take risks.  But what made me gasp was that I was looking at this quote from an educator’s point of view.  I would never teach my student to jump off a cliff and build wings on the way down.  You and I both know this business is built on risk management (and oftentimes lack thereof).  What puzzles me, though, is people talk about risk management like they really understand it.  Like they really have a handle on it.  So tell me why people continue to blow out?  I understand emotions are a major factor in a trader’s success or failure, too, but I would like to address risk first.  Address your risk first, and the money will come. 

Recently I had a new client come to me and say, “I have my risk parameters set, but I have put $10,000 in my account so many times that I think my friend who owns the IB where I hold my account now has a private jet with all the money I’ve gone through.”  So we started to talk about his risk parameters.  Most often the daily risk percentage a trader sets is too high for him/her to handle emotionally.  Monetarily/mathematically it might make sense, but personally it doesn’t.  Add to that, the risk they set for themselves might not be suitable for the markets they are trading.  Consider what you would feel like if you lost a $100 bill.  Would it make a difference?  Maybe not, but maybe if you lost a stack of $100 bills, that might sting a bit.  Where does your pain point lie? It’s important to get to know this.  You must realize, though, being extremely risk adverse will not work for trading.  When I first left the trading floor and tried to trade on my own, I was extremely risk adverse.  I couldn’t even swallow losing $25 when I was trading the emini S&P’s.  It was ridiculous.  I had to step away and retrain my thoughts in order to be successful as a trader. 

When I came back to trading my mentor introduced me to Forex.  Today I believe Forex is the greatest tool I know to use for training to trade in real dollars.  Note: I am not a big believer in Sim/Demo trading for months and months.  My philosophy is you need to get to know your platform which usually takes a couple of weeks and then you can start trading real dollars.  You will never trade the same on the SIM/Demo as you would with real money on the line. 

I had another new client come and tell me she had been Sim/Demo trading the spot EURUSD for 6 months.  I was appalled.  What a waste of time.  I asked her why she was doing this for so long and she said she was uncomfortable risking all that money real-time.  Again I sat down and started to talk with her about her risk parameters, crunched some numbers and walked her through the process. 

This is what the process looked like: We looked at the previous day’s chart of the spot EURUSD.  We found the high was 1.3118 and the low was 1.2974. The range of the day was 144 pips (high minus low).  I told her that was a pretty average day in the spot currencies.  They generally move about 100-200 pips per day.  Trading the professional level ($10/pip/contract) would have produced a $1,440 loss if

she bought the high and sold the low.  Now most people don’t buy the high and sell the low all in one trade, they usually perform somewhere in between.  We just wanted to familiarize ourselves with a worst-case scenario (not taking into account an unforeseen geopolitical event that would rock the market).  That calmed her down a bit.  I asked the client how many times she found herself trading in a day and she said, “A few.”  Then we talked about what it would look like if she had $10,000 in her account and she traded four times a day (I gave her an extra trade).  If she was willing to risk no more than 5% of her account in any one given trading day, she could risk $500.  In other words she could risk $125 per trade if she traded four times (1.25% per each trade).  That looked reasonable to her.  We were building a plan.  But what about the movement of the market?  Where did that fit back into the equation?  I told her to look at the market movement over a 30 minute period of time.  We figured out, on average, it was moving about 36 pips/30 minutes which was worth $360 per one contract at the professional level.  Aha!  We had previously figured out that she could risk $125 per trade and here we were saying she was going to be exposed to $360 worth of risk/reward over a 30 minute time period.  This did not add up.  I would be stuck on the Sim/Demo for six months, too, if I was trading this plan.  She was desperately undercapitalized. 

What we decided to do was to look at this scenario again, but this time we reduced the pip value - the most amazing thing about Forex!  Instead of taking on $360 of risk over a 30 minute period ($10/pip/contract) we changed it to $36 ($1/pip/contract).  According to her plan she could risk $125 per trade which meant she could actually trade up to a 3 lot ($36x3=$108).  Trading more than a one lot is a very freeing feeling.  If you trade a one lot, all you can do is get in and get out.  If you trade more than a one lot you can take profit quickly (or loss) and manage the others as the market moves.  Don’t you hate when you cover your position and the market keeps going in the direction you wanted it to go?  With more than a one lot, you can capture that extra movement.  We say this is like “having more bullets in your gun”.  You always want to have bullets in your gun.  But, I digress.

As you can see, risk management, if handled properly, can keep you out of trouble and on the right side of the market.  Take a look at the market you are trading and see if you are properly capitalized.  You may have to start with the smaller value ($1/pip/contract), but you can learn and grow from there instead of blowing all your money in the beginning.  On a side note, your IB or your FCM will tell you if you have enough money in your account according to margin, but don’t be misled.  Even though you might have enough to cover margin, do you have enough to trade more than one time?  This situation is similar to the one you encounter when applying for a mortgage.  The bank might tell you that you qualify for a larger mortgage that you can really handle.  When you crunch the numbers and see what you can absorb monthly and compare that to what the monthly payment will be on the loan, you might be shocked.  Actually these days banks don’t lend out too much money, so you might not have too much to worry about.

Additional Commentary from DTI’s Tom Busby:

Risk is personal and differs for everyone no matter what size you are trading – some people should always set risk at your own personal risk tolerance, and not based on your pocketbook.  Your emotional tolerance is what often determines whether or not you will be around tomorrow to make the next trade.  For example, some millionaires may be able to lose thousands of dollars in a day while some could lose $500 and not be able to sleep at night.  You need to ask yourself – where do you fit in?  It is crucial to think about the emotional penalties you incur on yourself and determine the comfort level of how you feel if a trade went so bad it was detrimental to your psychological health.  I have seen too many times where a trader believes he or she can withstand the mathematical risk of a trade but folds emotionally when the trade collapses and does not work out in their favor.  So, determine your risk tolerance on an emotional rather than mathematical level and be there for the next trade.  Best of luck in trading! 

Stephanie Radkay, Tom Busby